Looking out on the morning rain, I used to feel so uninspired.
A Natural Woman, 1967
In these Coronavirus times, it is a relief of sorts to listen to old music. It is calming and makes one think of other times; a form of escapism. Listening to Aretha Franklin this morning, the lyrics above struck me as being indicative of our feelings about the many layers of government’s response to the global crisis in which we are engulfed:
The weeks of Congress’ bumbling to pass a relief bill were disheartening; the initial divide along party lines was frustrating; and the media’s coverage of the entire process was, well, so uninspiring. Then there were the multi-stage Federal Reserve actions, astounding in their size and scope, and frightening by their very existence. In short, we start the second quarter of 2020 with far more questions than answers and all suffering to some degree from the circumstances in which we find ourselves. Nevertheless, good investment decisions in such times can lead to extraordinary outcomes.
To start this decision process, try making the impossible plausible. Do not allow the past to confine you but instead be liberated by the world facing you. It seems Black Swan events will occur with more frequency than anyone thought possible, and this will be the world confronting us going forward. After the 2008 Great Recession, we quickly seemed to adopt the same old ways of going about life. Of all things, debt was further embraced and exploded ever higher. We allowed our economy to hollow further with offshoring and industrial consolidation of critical industries. Look no further than drug manufacturing and airlines to see some examples painfully evident.
The world facing us, however, will likely repatriate more industries, perhaps some requiring government subsidy. Generic drug manufacturing and off-patent drug utilization are examples. We will need more capacity domestically, and not all elements will be profitable. The Bill and Melinda Gates Foundation has launched the Therapeutics Accelerator with $125 million in funding. This effort will fund trials of off-patent drugs in hopes of discovering Coronavirus remedies.
Airlines have consolidated to the point where we allow them to enjoy federal erasure of debt via bankruptcy, offload pension liabilities to the Pension Benefit Guarantee Corporation, and now support them with more direct financial taxpayer aid to sustain them. Perhaps in the future we will have more airlines and be less dependent on an oligopoly model, allowing some weaker players to dissolve. Banking, insurance, telecommunications, and others could see more competition as digital innovation permeates every industry. Looking ahead it is not hard to see a different construct emerging.
We do not feel the present financial conditions are solely a cause of the Coronavirus. In fact, we believe there are two major problems which have struck simultaneously: Without question the virus takes primacy, and the other is a long-festering debt accumulation that is now reaching a critical mass. This accumulation began in earnest after 2008, but probably started years earlier. At least in the last twelve years, we have added to the debt load in heaping handfuls at both government and corporate levels. This is largely in part to artificially low interest rates imposed by the Federal Reserve after the 2008 melt down. Despite the Fed’s best efforts, it could never get a meaningful rise in rates without markets rebelling. Consequently, we gorged on low interest debt. Corporations initiated huge share buybacks funded by debt, dividends paid with debt, but strangely, few new capital expenditure projects. This activity increased corporate debt levels to around $9 trillion in the last ten years.
Inadvertently we have stumbled into an experiment in Modern Monetary Theory (MMT), a unique concept calling for unlimited debt provided you have a stable sovereign currency and no inflation. The sky is the limit. The theory posits that debt expansion is normal and should occur unbridled in the absence of inflation. With global demand for our dollar, we should print all we can, and fund all the projects that we can. Print, print, print. Taxes would be the answer when, and if, inflation hit the model. Taxes would put the brakes on consumption and be utilized for debt service. Once again, we find it uninspiring.
We are now entering the MMT zone and we will find how much printed money the economy can absorb. The theory asserts that once you see inflation you have hit the limit. After 2008, we saw the Fed’s balance sheet soar from $950 billion to $4.5 trillion. With this latest intervention we now cross the $5 trillion mark with the $6 trillion mark coming in very short order.
This has, without question, been accelerated by the virus. The problem, however, has been brewing in the last six months. Last October, the Federal Reserve interceded into the Treasury Repurchase market (“repo market”) because interest rates on this very short-term debt market soared to near 10%. The Fed assured us not to worry as they injected large sums to restore order. The repo market seas had not fully calmed when the virus struck, and no clear explanation was ever produced to explain the persisting repo issues. The massive multi-trillion-dollar relief programs advanced by Congress and the Fed are just now being understood. It will take time to understand the intricacies and impacts to our lives and to balance sheets.
The positive news, however, is the lack of failing institutions and funds. Despite not liking the market’s recent gyrations, it has functioned properly and transitioned gracefully in the absence of floor traders. No significant hedge funds have failed thus far. Allianz, the parent of PIMCO, has liquidated two hedge funds, but these are negligible. It bodes well if this trend holds and leveraged funds remain solvent.
Looking forward to the world that awaits us, it seems apparent that investors’ funds should flow into certain areas. The medical and health sectors will benefit greatly. Many cracks in the public health system have been exposed and no doubt repairs will begin. Medical equipment makers, drug companies, hospitals, tele-medicine, and medical software makers all are in the sweet spot. Our last Strategy Report dealt with the emerging genetic editing technology, and this is now front and center as funds rush into the field. This will accelerate our knowledge of the human genome as vaccines and medications are tested and utilized. It is exciting and hopeful in these uninspiring times of social distancing. Biotech funds will also be good hunting grounds for investors, spreading risk among many smaller innovative companies.
Investors should investigate following the Federal Reserve’s money into credit markets. With billions being used to buy bonds and mortgage backed securities it could offer opportunity for growth. Real Estate Investment Trusts (REITs) have been hit hard in this downturn and offer value in the proper segments of real estate. And perhaps most compelling, technology will undoubtedly continue to benefit as we are now using it more than ever. The “FANG” stocks of Facebook, Apple, Netflix, and Google (Alphabet) are entering our lives in more ways daily- just when we were thinking their reach had required government regulation! New companies like ZOOM are becoming everyday video applications for students, businesses and governments. They have already reached “verb status”: “Just ZOOM me tomorrow.”
A word on energy is called for: As oil prices hover below the $20 mark we find Russia and Saudi Arabia locked in a duel to try and upend the other. In the meantime, US shale producers are caught in-between. Their balance sheets will not hold with $20 oil, and defaults in their corporate bonds are expected. This pressure has pushed virtually all oil stocks to incredibly low levels. With the virus shutdown there is less demand for oil and stockpiles are growing. Something must give and we feel this is another opportunity. Headwinds remain as the world seeks to lower its carbon footprint, consume less oil, and fund alternative sources of energy. Even with these issues we feel these prices offer enticing entry points and good dividend yields offered by the oil majors.
We should not forget, however, that energy is a two-sided coin: Low oil prices may squeeze the balance sheets of producers and refiners, but consumers and manufactures relish the cheap and abundant resource. So much of the necessities in our life are made from oil, including much of the critical plastics used in life-saving health care. Without question, cheaper energy costs will help drive the ultimate economic recovery.
So many changes loom. Everything from voting to education, taxation to medicine stand to offer opportunity. Now is the time to be putting these thoughts into action and preparing for the new world that will emerge. The morning rain that had us so uninspired is lifting, there are patches of sun, and we cannot wait! Let us stay safe during this virus episode, keeping as much weight off of our healthcare workers as possible, and know it is time to get inspired!
E.B. “Chip” Beard April 2020
